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The Cash-King Portfolio, June 25, 1998

Austin, TX (June 25, 1998) -- I thought I'd begin with a little magic to ensure that you're going to pay attention to this full report. Here you go, click, play, and come back focused: Hondo! Magic with a message!

All right, a little entertainment out of the way, let's get down to business (with a little Folly).

Today, I'm continuing my series on what a corporation is. Now, most companies start out small. "Two Guys in a Garage, Inc." You've heard of them. It's actually true of The Motley Fool, by the way -- though the Fool was two brothers in an old shack in Historic Old Town Alexandria, VA. Anyway, though it might not seem true at first blush, most small do companies have options that aren't open to larger ones. They can be nimble. Oh, and one of the biggest advantages to being small is the ability to elect "Subchapter S" status.

Bigger corporations pay loads of money in taxes -- with federal and state income taxes running up to 40% of profits. Yep, 40%. Add to it that the dividend payments to shareholders that will be taxed as income... and... ouch. Small companies can at least start as "S-Corporations" -- a small business corporation, which passes its earnings on directly to its owners, where they are taxed only once, via income taxes.

The corporation itself pays no taxes while operating under subchapter S. It's a good deal if you can get it, but there are hurdles to jump through. Then finally, once you're growing steadily and of a certain size, you have to crossover into C-Corporation status.

Being big isn't the end of the world, though. Probably the biggest advantage of being a larger company is the option of going public. Once a company has a promising enough future that strangers walking down the street (well, Wall Street) might want to invest in it, the company can find a bank or brokerage firm to organize and sponsor an Initial Public Offering (IPO).

There's a lot of paperwork and details handled by the sponsor of the IPO, but the result is that the company gets registered with one of the public stock exchanges, receives a stock symbol, and sells a set number of shares directly to investors. Of course, the most promising IPO stocks are often snapped up by the large fund managers before individuals like you and me can buy into them. (Aside: It's a sham that IPOs are listed as having been priced at anything but their first trade. Accounted for that way, the IPO market becomes incredibly unattractive for small investors because the stocks often open far above the stated "offering price.")

The direct advantage of going public is an enormous amount of capital can be raised. If the IPO is successful (people are interested and the company gets a good price for its stock), it'll probably generate several million dollars. This can turn a promising garage enterprise, with a couple thousand customers and a patent or two, into an enormous multi-national concern in a matter of months. Literally.

The company can also do a Secondary Offering (as many as it wants, actually, although they're all called "Secondary") and sell additional newly issued shares whenever it needs to, straight into the market. Though it raises cash, issuing more shares dilutes the value of the existing shares, and can drive the price of the stock down. You have to be careful with secondaries -- they're essentially debt vehicles laid directly on the backs of existing shareholders. What's important to know is whether or not the company doing the secondary offering can generate a return on the capital raised that will be larger than the dilution represented by the additional shares. Over time, a good company certainly can.

For a public company to maintain unquestioned control of the business, it needs to hold at least 50% of the stock. Anything less and there's a risk that a larger entity (or consortium of companies) might buy it out. Most companies are less than 50% internally owned, which is why you hear of these various poison-pill provisions to block unwanted takeovers.

Another benefit of being large is that the company can give stock to its employees as part of their compensation, potentially keeping them extremely happy without needing cash on hand (a la Microsoft). A publicly traded stock is really a license for a company to print money (which can, of course, cause serious inflation in their private little currency if they overdo it). Often companies will give stock to employees years before an IPO, on the theory that some day that stock could be worth a fortune.

When a company goes public, its stock hits an exchange that is simply a marketplace for stocks, a big flea market where people can sell or buy whatever businesses they want. There are dozens of different exchanges where stocks can be listed, but the big two are the New York Stock Exchange (www.nyse.com) and the National Association of Securities Dealers Automatic Quotation (www.nasdaq.com).

The NYSE still keeps big marble buildings in New York City filled with stock trading pits where chubby men with high blood pressure wave little pieces of paper at each other and shout. NASDAQ has been electronic from day one, with administrative headquarters in Washington D.C. (near the Fool, incidentally). Several other electronic systems (such as Datek's Island) have been created to match offers to buy and sell the stock, but generally it's your broker's problem determining which one to use to buy or sell your stock. Click here (A New System) for the article I did on Datek's system a month ago.

There are many regulations and requirements imposed on publicly traded companies by the SEC and the exchanges themselves. At the very least, they must file Annual Reports (10-K) and Quarterly Reports (10-Q) containing financial performance results in a standardized format. This information is available from the U.S. Securities and Exchange Commission's "Edgar" database, on the web at www.sec.gov or slightly more accessible at www.edgar-online.com. Even better is www.freeedgar.com -- which provides all the filings for free.

So that's where all these companies -- from Cisco to Coca-Cola, from American Express to Pfizer -- came from. I just figured somebody out there might be curious. I was, which is why I learned all that. Fool on!